Post on 16-Jan-2016
The Determination of Interest Rates
I. Determinants of the Interest Rate LevelA. Real Rate of Interest
• Definitions– Interest Rate: The price paid for the use of money.
– Nominal Rate: The interest rate expressed in terms of nominal dollars.
– Real Rate:The interest rate expressed in terms of real dollars.
• Equilibrium Real Rate – Supply of Funds (e.g., propensity of household
to save)
– Demand for Funds (e.g., expected productivity of capital)
B. Macroeconomic Factors
• Economic Growth
• Rate of Inflation(1 + r)(1 + i) = (1 + R),
where
r = real rate,
i = inflation rate, and
R = Nominal rate.
Fisher Equation
R = r + E(i)
The nominal rate equals to the real rate plus the expected rate of inflation.
• Money Supply
• Taxes and Government Spending
R(1-t) - i = (r + i)(1 - t) - i
= r(1 - t) - it.
The real after-tax rate is approximately the after-tax nominal rate minus the rate
of inflation.• Foreign Flow of Funds
C. Microeconomic Factors• Default Risk• Administrative Costs • Maturity• Liquidity• Special Provisions (Callability, Convertibility)
II. Theory of Interest Rate
A. Interest Rate Structure
B. Theories• The Liquidity Preference Theory
– Demand for Money
– Supply of Money
• Loanable Funds Theory– Demand for Loanable Funds
– Supply of Loanable funds
III. Interest Rates Over Time
• 1973 Inflation caused by the energy crisis
• 1973-4 Recession
• 1980 Inflation caused by strong economic growth
• 1982 Recession
• 1989 Capital flow caused by a unified Germany
• 1990 Recession
• 1994 Economic Expansion
• 1997 Asian Financial Crisis
IV. Forecasting Interest Rates
ND = DA - SA
= [Dh+ Db+ Dg+ Dm+ Df] - [Sh+ Sb+ Sg+ Sm+ Sf],
where
ND = net demand for loanable funds,
DA = aggregate demand for loanable funds,
SA = aggregate supply of loanable funds,
D = demand, S = supply,
h = household sector, b = business sector,
g = government sector, m= money supply,
f = foreign sector.